20 June 2011
This is how Krugman's argument goes:
Many private investors -- plus economists and economic commentators who never understood Keynes -- looked at (a) and confidently predicted soaring interest rates. Economists who did get Keynes looked at (b) and said that rates would stay low unless government borrowing was large enough to return the economy to something like full employment, which was unlikely.
The economic argument for rates staying low, by the way, wasn't complicated: it amounted to saying that the IS curve looked like this: [there's a fancy graph here which can be seen at the original link] and that there was no reason for the interest rate to rise, even with large government borrowing, unless that borrowing shifted the IS curve enough to the right to bring the economy above the zero lower bound. The subtlety arose from understanding that at each point on that IS curve the supply and demand for loanable funds are in fact equal, that liquidity preference and loanable funds are both true.
And here we are, two-plus years later, and the interest rate on 10-year U.S. Treasuries is only 2.94 percent. This should count as a triumph of economic analysis: the model was pitted against the intuitions of practical men, making a prediction many people considered ridiculous -- and the model was right.
I thought the idea of ceteris paribus was something well known to every economist. But apparently when fancy graphs fill up the brain, common sense has to make way.
Economists like Krugman, Mark Thoma and Brad deLong remind me of pre-Galilean scholars. Whenever the latter came across a difficult question they went back to Aristotle, who of course had the answer, so no one else needed to think. And thus for two thousand years they believed that heavier objects fell faster than lighter objects and that men have more teeth than women.
Readers might want to read the following paper by Prof Ronald McKinnon of Stanford University: Zero Interest Rates and the Fall in US Bank Lending